FAQ Real Estate Investment Trust Morrison Foerster | 8 (1) (less than 100 holder exemption) or Section 3(c)(7) (qualified purchaser2 exemption) under the Investment Company Act. Most equity REITs hold assets primarily through direct or indirect whollyowned or majority-owned subsidiaries that generally meet the Section 3(c)(5)(c) exemption and therefore do not constitute “investment securities” allowing the equity REIT to hold less than 40% of its total assets in “investment securities”. Most mortgage REITs avail themselves of the same exemptions and exceptions; provided that the analysis can be more complex based on the composition of its mortgage assets. Qualifying assets for purposes of the Section 3(c)(5)(c) exemption include senior whole mortgage loans and certain B-notes and mezzanine loans that satisfy various conditions set forth in SEC no-action letters and other guidance that the SEC staff has determined are the functional equivalent of senior loans for the purpose of the Investment Company Act. Generally, B-notes and mezzanine loans that do not satisfy such conditions as well as preferred equity investments and CMBS are generally treated as real estate-related assets for this exemption. In addition, certain securitization subsidiaries of mortgage REITs that hold specified assets, issue fixed-income securities and meet certain other conditions rely on an exemption under Rule 3a-7 of the Investment Company and therefore are not considered an “investment security” held by the REIT. Private REITS can rely on the exceptions and exemptions described above or on Section 3(c) (1) or Section 3(c)(7). If a REIT does not meet the exemptions or exceptions described above, unless the REIT qualifies for another exemption or exception under Section 3(b) or the other provisions of Section 3(c) of the Investment Company Act, the REIT will be viewed as an investment company and required to comply with the operating restrictions of the Investment Company Act. These restrictions are generally inconsistent with the operations of a typical REIT. Therefore, most REITs monitor their Investment Company Act compliance with the same level of diligence thy apply to monitoring REIT tax compliance, as a violation of either set of rules can lead to material adverse consequences. Operating A REIT What types of assets do REITs own and manage? Broadly speaking, REITs generally own real property or interests in real property and/or loans secured by real property or interests in real property. What are the limitations on the types of assets REITs may own and manage? Entities must satisfy various income and assets tests in order to qualify for treatment as a REIT. These tests effectively limit the types of assets that REITs can own and manage to real estate or real estate related assets. How does a REIT maintain compliance with REIT tax requirements? The types of assets that a REIT can hold and the types of income it can earn are limited by the REIT rules. Therefore, a REIT must establish procedures, typically in coordination with its outside auditors, tax preparers and legal counsel, to ensure that it is investing in the correct types and proportions of assets and earning the right types and amounts of income. See “Tax Matters” below. How does a REIT finance its activities? Because a REIT must annually distribute at least 90% of its ordinary taxable income in order to maintain its REIT status, a REIT may not retain earnings like other companies (although cash generated by REITs often is in excess of their ordinary taxable income and therefore REITs often do have cash they can retain). As a result, REITs often require capital from outside sources to buy 2 Section 2(a)(51) defines “qualified purchaser” as: “(i) any natural person (including any person who holds a joint, community property, or other similar shared ownership interest in an issuer that is excepted under section 3(c)(7) [15 USCS § 80a-3(c)(7)] with that person’s qualified purchaser spouse) who owns not less than $5,000,000 in investments, as defined by the Commission; (ii) any company that owns not less than $5,000,000 in investments and that is owned directly or indirectly by or for 2 or more natural persons who are related as siblings or spouse (including former spouses), or direct lineal descendants by birth or adoption, spouses of such persons, the estates of such persons, or foundations, charitable organizations, or trusts established by or for the benefit of such persons; (iii) any trust that is not covered by clause (ii) and that was not formed for the specific purpose of acquiring the securities offered, as to which the trustee or other person authorized to make decisions with respect to the trust, and each settlor or other person who has contributed assets to the trust, is a person described in clause (i), (ii), or (iv); or (v) any person, acting for its own account or the accounts of other qualified purchasers, who in the aggregate owns and invests on a discretionary basis, not less than $25,000,000 in investments.”
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